Purchasing power parity

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GDP per capita adjusted for purchasing power parity (PPP) in the world, 2007
Purchasing power parity (PPP) is an economic theory and a technique used to determine the
relative value ofcurrencies, estimating the amount of adjustment needed on the exchange rate between
countries in order for the exchange to be equivalent to (or on par with) each currency's purchasing power. It
asks how much money would be needed to purchase the same goods and services in two countries, and uses
that to calculate an implicit foreign exchange rate. Using that PPP rate, an amount of money thus has the same
purchasing power in different countries. Among other uses, PPP rates facilitate international comparisons
of income, as market exchange rates are often volatile, are affected by political and financial factors that do not
lead to immediate changes in income and tend to systematically understate the standard of living in poor
countries, due to the BalassaSamuelson effect.
The idea originated with the School of Salamanca in the 16th century and was developed in its modern form
by Gustav Cassel in 1918.
[1][2]
The concept is based on the law of one price, where in the absence
of transaction costs and officialtrade barriers, identical goods will have the same price in different markets when
the prices are expressed in the same currency.
[3]

Another interpretation is that the difference in the rate of change in prices at home and abroadthe difference
in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate.
Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which
means that for the purposes of many international comparisons, countries' GDPs or other national income
statistics need to be "PPP-adjusted" and converted into common units. The best-known purchasing power
adjustment is the GearyKhamis dollar (the "international dollar"). The real exchange rate is then equal to the
nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the
real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run
and long run deviations from this value, for example due to reasons illuminated in the BalassaSamuelson
theorem.
There can be marked differences between purchasing power adjusted incomes and those converted via market
exchange rates.
[4]
For example, the World Bank's World Development Indicators 2005 estimated that in 2003,
one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity
[5]

considerably different from the nominal exchange rate. This discrepancy has large implications; for instance,
when converted via the nominal exchange rates GDP per capita in India is about US$1,704
[6]
while on a PPP
basis it is about US$3,608.
[7]
At the other extreme, Denmark's nominal GDP per capita is around US$62,100,
but its PPP figure is US$37,304.
Contents
[hide]
1 Measurement
o 1.1 Law of one price
o 1.2 Big Mac Index
o 1.3 OECD comparative price levels
o 1.4 Measurement issues
2 Need for adjustments to GDP
o 2.1 Updating PPP rates for GDP
3 Difficulties
o 3.1 Range and quality of goods
o 3.2 Trade barriers and nontradables
o 3.3 Departures from free competition
o 3.4 Differences in price level measurement
4 Global poverty line
5 See also
6 References
7 External links
Measurement [edit]
The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of
goods to compare purchasing power across countries.
[citation needed]

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a
uniform price level; rather, the difference in food prices may be greater than the difference in housing prices,
while also less than the difference in entertainment prices. People in different countries typically consume
different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price
index. This is a difficult task because purchasing patterns and even the goods available to purchase differ
across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services.
Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat
more bread; Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from
that calculated using China as a base. Additional statistical difficulties arise with multilateral comparisons when
(as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs
can provide a more stable multilateral comparison, but at the cost of distorting bilateral ones. These are all
general issues of indexing; as with other price indices there is no way to reduce complexity to a single number
that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many
problems that arise in using market exchange rates to make comparisons.
For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was USD 0.91, and in Norway the price
was USD 6.27.
[8]
The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite
all of the variables that contribute to the significant differences in price. More comparisons have to be made
and used as variables in the overall formulation of the PPP.
When PPP comparisons are to be made over some interval of time, proper account needs to be made
of inflationary effects.
Law of one price [edit]
Although it may seem as if PPP and the law of one price are the same, there is a difference: the law of one
price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is
true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some
argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not
true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.
[3]

The purchasing power parity theory states that the exchange rate between one currency and another currency
is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent.
Big Mac Index [edit]


Big Mac hamburgers, like this one fromJapan, are similar worldwide.
Main article: Big Mac Index
An example of one measure of the law of one price, which underlies purchasing power parity, is the Big Mac
Index, popularized by The Economist, which compares the prices of a Big Mac burger
in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because although it is
based on a single consumer product that may not be typical, it is a relatively standardized product that includes
input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread,
lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc.
In theory, the law of one price would hold that if, to take an example, the Canadian dollar were to be
significantly overvalued relative to the U.S. dollar according to the Big Mac Index, that gap should be
unsustainable because Canadians would import their Big Macs from or travel to the U.S. to consume them,
thus putting upward demand pressure on the U.S. dollar by virtue of Canadians buying the U.S. dollars needed
to purchase the U.S.-made Big Macs and simultaneously placing downward supply pressure on the Canadian
dollar by virtue of Canadians selling their currency in order to buy those same U.S. dollars. The alternative to
this exchange rate adjustment would be an adjustment in prices, with Canadian McDonald's stores compelled
to lower prices to remain competitive. Either way, the valuation difference should be reduced assuming perfect
competition and a perfectlytradable good. In practice, of course, the Big Mac is not a perfectly tradable good
and there may also be capital flows that sustain relative demand for the Canadian dollar. The difference in price
may have its origins in a variety of factors besides direct input costs such as government regulations
and product differentiation.
[3]

In some emerging economies, western fast food represents an expensive niche product price well above the
price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury
import. This relates back to the idea of product differentiation: the fact that few substitutes for the Big Mac are
available confers market power on Mcdonalds. Also, with countries like Argentina that have abundant beef
resources, consumer prices in general may not be as cheap as implied by the price of a Big Mac.
The following table, based on data from The Economist's January 2013 calculations, shows the under (-) and
over (+) valuation of the local currency against the U.S. dollar in %, according to the Big Mac index. To take an
example calculation, the local price of a Big Mac in Hong Kong when converted to U.S. dollars at the market
exchange rate was $2.19, or 50% of the local price for a Big Mac in the U.S. of $4.37. Hence the Hong Kong
dollar was deemed to be 50% undervalued relative to the U.S. dollar on a PPP basis.